Various approaches can be considered for regulating ICOs and tokens. We focus on the features of ICOs and tokens as securities and study their regulations in that context.
3.1 Types of Tokens and Proper Regulations
ICO is a generic term for issuing electronic tokens (or simply tokens) to raise funds from the public for entrepreneurial purposes. There are various types of tokens. In addition to the IOU tokens discussed in the previous section, virtual currencies that are issued on blockchain in exchange for IOU tokens are also referred to as tokens.
Different countries adopt different classifications for tokens in light of their eco- nomic functions and purposes. Below, we explain the Swiss classification, which is relatively simple and easy to understand. In February 2018, the Swiss Financial Market Supervisory Authority (FINMA) issued a guideline that classifies tokens into three categories by focusing on their economic function and purpose. They are:
1. Payment token: A payment token is a synonym for a virtual currency. It is used as a means of payment for goods and services and has nothing to do with other development projects.
2. Utility token: A utility token is a type of ticket that is to be used for acquiring a specific digital application or service.
3. Asset token: An asset token is the representation of a claim concerning assets, for example, to receive dividends and interest payments from companies and income-generating businesses.
Of course, there are many real-world tokens that do not fit one of these categories.
FINMA points out that some tokens have features that overlap more than one of these categories.
The security token described in the previous section is included in the asset token under the FINMA classification. An asset token is similar to stocks and corporate bonds. It gives the token holder the right to receive dividends and property distribution from the business. For this reason, FINMA specifies that asset tokens are regulated as securities. In many countries, similar asset tokens are regulated as securities. In Japan as well, under the Financial Instruments and Exchange Act, an asset token is classified as a security as a group investment scheme share (Financial Instruments and Exchange Act Article 2, paragraph 2, item 5) and is considered to be subject to that regulation.
Payment tokens are currencies, and FINMA does not treat them as securities.
Bitcoin is a good example of a payment token. It is also common in many countries that tokens that do not have features other than a currency are not treated as securities.
It has been argued that utility tokens as well are not like securities because they are just like tickets for using services. FINMA also states that if the sole purpose of
a token is to give the right to use digital applications, the token is not regarded as a security but as a right to use services, so long as it does not function as an investment.
In this regard, the SEC has taken a position that whether a token is regarded as a security depends on its economic substance, not whether it is called a utility token (Munchee case. Dec. 11, 2017, Exclusion order dated). This case addressed whether the token that Munchee, which operates the restaurant evaluation app used on the iPhone, attempted to issue by ICO (named “MUN token”) is a security. In its white paper, which explained the business of a company planning an ICO, Munchee emphasized that the value of the token issued by the ICO was expected to appreciate because of the following business plan. The company would issue MUN tokens to the users who uploaded pictures and reviews on restaurants that they visit, and, in the future, make it possible for MUN token holders to pay at the restaurants reviewed.
Moreover, the company made firm commitment to make it possible for token holders to resell their tokens in multiple secondary markets. In light of these facts, the SEC concluded that although the MUN token did not promise to pay dividends, Munchee created a reasonable expectation among purchasers of MUN tokens that its value will appreciate once the company made the software application available to the public.
In this finding, the SEC followed its conventional position that a device creating a reasonable expectation that investors will benefit from the business effort of the investee is an investment contract and is categorized as a security. This shows the SEC’s position that tokens creating such an expectation are regarded as a security under US law. In short, although its issuer calls it a utility token, the MUN token, creating an expectation that its value will appreciate, is regarded as a security. This agrees with the FINMA guidelines.
On April 3, 2019, the SEC announced a framework to determine whether a par- ticular digital asset falls in the category of an “investment contract” (Securities and Exchange Commission2019a). The SEC clearly pointed out that the conventional test, described above in relation to Munchee, applies in determining whether the ICOs and the sales of other digital assets are covered by the Securities Act. In addi- tion, it provided various examples that may or may not be treated as an “investment contract.” At the same time, the SEC communicated that the token that TurnKey Jet (TKJ) was about to issue is not regarded as an “investment contract” for the following reasons (Securities and Exchange Commission2019b).
• TKJ will not use any funds from Token sales to develop the TKJ Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold;
• the Tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold;
• TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform;
• TKJ will sell Tokens at a price of 1 USD per Token throughout the life of the Program, and each Token will represent a TKJ obligation to supply air charter services at a value of 1 USD per Token;
• If TKJ offers to repurchase Tokens, it will only do so at a discount to the face value of the Tokens (1 USD per Token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the Tokens; and
• The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for any increase in the market value of the Token.
This shows that the SEC also takes into consideration technological innovation, while assuming that whether a token falls under the Securities Act is determined on a case-by-case basis regarding factual manners. Thus, it is apparent that the SEC is trying to establish clear criteria for blockchain token issuers.
3.2 Information Disclosure
If a token is regarded as a security under the laws of a particular country, before the issuance, the issuer is required to disclose material information concerning the issuer’s business, although the requirements differ across countries. There are excep- tions in which this requirement does not apply; for example, the cases in which targeted investors are limited to a small number of individuals or to professional informed investors. This requirement on information disclosure is to eliminate the so-called asymmetry of information; that is, to ensure that the investors who are interested in buying the security to have all the material information that would be relevant for the valuation of the issue. In short, the main purpose is to let investors make informed decisions.
The disclosure of information at the time of a security is referred to as initial disclosure. For the case in which the issuer’s business continues after the initial issuance, periodic disclosure of information is required if the issuer’s security is continuously circulated on the market over time. The holders of securities often purchase a security in hopes of recovering their investments by selling it later. For the secondary market of such securities to function properly, it is necessary for the sellers and buyers of the securities to evaluate the value of the securities based on the same information. Therefore, if issued securities are expected to be distributed, the issuers of the securities are required to periodically disclose important information on the securities. This is often referred to as continuous disclosure or ongoing disclosure.
If a token is identified as a security, the ICO for that token will usually be viewed as an act of soliciting purchases of securities to an unspecified and/or large number of people. The issuer is, therefore, required to disclose relevant information regarding the business relating to the token. Moreover, when the token is expected to be traded on the market over time, it should be assumed that the issuer will be required to disclose relevant information over time.
3.3 Blockchain Characteristics and Security Regulation Conformance
As discussed above, there are cases in which the ICOs on token are subject to securi- ties regulations, and, therefore, to information disclosure requirements. However, as explained below, it is unclear whether applying securities regulations and requiring information disclosure is enough to protect the holders of tokens and those interested in investing in tokens.
First, there are many kinds of tokens, and their contents vary. In comparison with traditional securities such as stocks and bonds where the holder’s right is legally established, it is unclear what kind of right you may obtain if you hold the token.
That is why it is important to let investors know what right they will obtain and what they can do with the token. Therefore, it is undoubtedly important to require disclosure of information for token issuance. It is also possible to impose damages, criminal penalties, and administrative sanctions under securities laws on those who give false or misleading information. At this moment, there is no legal protection for a token holder’s right to monitor the progress of the project, nor is the method of monitoring the progress stipulated. Under corporate law, stockholders are given the right to attend a general meeting of shareholders and make decisions on important matters and to receive business reports and financial statements. In contrast, the legal relationship between the token holders and the token issuer is unclear, for there is no legal provision for the nature of the token. As such, it is not clear what token holders can claim against the token issuer or what rights they have. At this moment, it is unclear whether any contractual relationship exists between the token holder and the token issuer, and what contents the contract, if it exists, may have. Therefore, for now, we can only take a case-by-case approach.
Second, blockchain technology is characterized by its ability to provide open- source and distributed ledgers. In a typical blockchain project, the protocol and software will be open to the public upon completion; once publicly released, the original developers cannot modify the contents freely. It is the nature of open-source programs that, once publicly released, there are no owners of the system/network and thus no administrator can be identified. The developer is not obligated to perform maintenance after completion. Even if the developer of the project funded by an ICO is asked to perform continuous disclosure, once the project becomes public, the developer will no longer be either the owner or the administrator. Under such circumstances, it is unclear whether such continuous disclosure is possible.
Some projects do not adopt an open-source model, in which case continuous disclosure is theoretically possible. However, because problems on protocol and software are most of the time not understandable for ordinary investors, the problems arising from asymmetric information might be even more serious.
Logically speaking, it is difficult to establish the relationship between the business performance to which a token is linked and the value of the token except for asset tokens for which the distribution of dividends and a residual claim are explicitly guaranteed. If, like the MUN token issue, the token issuer explicitly explains to
investors that the token value is likely to go up once the project become publicly available, it is not very clear how the token value is affected by information on the development of the project and on business performance after the public release of the project. If no clear explanation is given as to why the token value will rise, the information disclosed could become misleading rather than informative, although the positive aspect of information disclosure should not be discounted.
Third, generally speaking, it is extremely difficult for nonexperts to evaluate the success probability of a new project. This implies that if information is completely disclosed before an ICO, it is unclear whether it is permissible to accept investment from anyone. This is not limited to token issuances; the exact same issue arises in the case of investment in venture companies. In that case, experts in venture investment such as venture capital companies examine and evaluate a business model in a direct interview with an entrepreneur; this process is called due diligence. Usually, at this stage, venture companies do not seek investment from the general public but rather invite a few specific experts. For this reason, venture capital offerings of stocks are treated as an exception to the SEC’s disclosure requirements. Typically, venture capital investors negotiate out a deal with entrepreneurs with respect to various rights and obligations on equity investment.
An IPO of corporate shares to the public is conducted after a company’s business is expected to generate profits without big risks. In a typical IPO, an investment bank or securities company underwrites the initially offered shares; that is, they purchase the entire offer at a price negotiated right before the IPO. In the real world, some IPOs fail, meaning that the initial market price of a share is set below the negotiated price.
To avoid such failures, even IPOs are subject to a process in which the investment bank or securities company fully evaluate the business of an equity issuer before the IPO.
In short, before corporate shares are made available to the general public for investment, there is a long process of evaluating companies at the stages of venture capital investment and IPO underwriting.
It could be argued that an ICO requires even deeper scrutiny of a project than an IPO, because ordinary investors are, at least at this moment, far less familiar with the technological aspects of an ICO than general businesses that are represented by an IPO. Even if disclosure of information is sufficient for an expert’s evaluation, it may not be appropriate to solicit investment from those who are not experts at the stage at which the business plan of a project is subject to a large risk.
Fourth, there is an important question as to which country’s security regulations should govern an ICO. In many ICOs, investments have been made in virtual currency through the Internet; for example, MUN tokens were available to individuals not only in the USA but also in every other country. In that case, an important question is: under the regulations of which country are investors protected? In all countries, securities laws are drafted primarily to protect domestic investors. Moreover, the details of securities laws and regulations differ across countries. As a result, the regulation of ICOs involves rather messy international legal issues.
3.4 Desirable ICOs
If the future value of a token may depend on the success or failure of a particular project, it may not be appropriate to allow an issuer to solicit investment from ordinary investors before the issuer completes the project. This is also the case even if the token issuer explains that the project is not yet developed.
In practice, this concern could be substantially eliminated by treating the token as a security. If a token is recognized as a security, and if the ICO is subject to both initial and continuous disclosure of information under the securities law, it will be a considerable burden on the token issuer. As a result, token issuers will avoid an ICO, which subjects the issuer to the disclosure restrictions. Specifically, as in the case of stocks, the company will offer tokens only to certain specialists such as venture capital and prohibit the transfer of tokens by investors who have obtained tokens for the time being. A token ICO will be conducted when the development of the project has progressed considerably. At that time, issuance disclosure and subsequent disclosure will also be required if securities regulations are applied.
Even if a project is to develop an application that is absolutely distributed and decentralized, and if the developer does not have any right after the development is completed, it may have a feature of a utility token that is associated with the right to use some service offered by the software. Even in that case, if the value of the token is affected by the state of that service, continuous disclosure should be required with respect to the service, once the token starts circulating on the open market. In such continuous disclosure, care must be taken that the disclosed information does not mislead investors with respect to the relationship between the success or failure of the business and the value of the token.
For payment tokens, their values are not related to the success or failure of other projects. In that case, a token may be a security. For tokens that are not subject to securities regulations, it is not expected that ICOs will be suddenly barred. Even in that case, certain types of information should be disclosed. They are: (1) the iden- tity and history the token issuer (and the director of the issuer if the issuer is a corporation); (2) the current status, development schedule, and technical issues of the program/protocol; (3) the rights guaranteed by the program/protocol upon com- pletion; (4) plans for future maintenance and the way to cover the resulting costs;
and (5) methods for program/protocol modification in the future. Moreover, it is important to disclose details on the protocol and the system of protocol maintenance in the future; more specifically, for the case in which a foundation organized by experts is expected to conduct voluntary evaluations and maintenance, the process of organizing the foundation should be explained. In addition, it may be worth con- sidering having third-party experts evaluate the program or protocol and to disclose the evaluation.
Of course, it is of utmost importance to explain the content of the token and the right that comes with ownership of the token. This implies that regardless of the type of token (i.e., whether it falls into the category of a security), it is necessary to disclose accurate information on the ICO, including: (1) the function/use of the token; (2)